How to spot undervalued LICs

By Will SpraggettNovember 2015min read

Listed Investment Companies (LICs) are investment companies that offer exposure to a professionally managed portfolio of securities. They offer a wide range of exposure to differing asset classes, including domestic equity, international equity, fixed income and alternatives.

Similar to managed funds, LICs are also backed by a tangible pool of assets, which in aggregate now account for $28.4 billion in market capitalisation.

An LIC operates in a closed-ended structure and its shares trade on an exchange similar to any other listed security. This means that new shares cannot be created or redeemed at asset backing; only existing securities can be bought and sold on market.

Unlike a traditional open-ended managed fund, this gives the investment manager access to a stable pool of capital that can be invested for longer periods without being exposed to capital inflows (applications) and outflows (redemptions), which can adversely impact on investment decisions.

Pre-tax or post-tax NTA?
LICs are required to disclose their pre-tax and post-tax NTA (net tangible assets) per share every month, 14 days from month’s end. NTA refers to the total assets of a company minus any intangibles, such as goodwill, and less liabilities.

Pre-tax NTA implies that it is the NTA before any tax is incurred. However, it is actually the NTA after tax on realised positions has been expensed, but before taxable gains on unrealised positions has been taken into account.

Post-tax NTA factors in all tax, realised and unrealised, in effect outlining the value of the portfolio if all the positions were to be exited.

This compares to managed funds which generally only disclose the net asset value (NAV). This is the value of an entity’s assets less the value of its liabilities and is disclosed on a per unit basis. Most unit trusts will not disclose NAV or performance on an after-taxation basis, given the trust is generally not taxed at the vehicle.

The issue here is that the tax impact occurs at the individual level, which means a manager would need to incorporate the particular tax circumstance on each investor, which is difficult to do en masse.

Pre-tax NTA is generally viewed as the most relevant measure for an LIC, as unrealised gains may take many years to realise and the tax impact will not affect the portfolio until that occurs. Further, portfolios that do have a higher turnover tend to unlock capital gains more frequently. Consequently, pre-tax and post-tax NTA for these companies generally trade closer together.

Listed on an exchange in a closed-ended structure means that an LIC does not necessarily trade at the fund’s pre-tax NTA. In fact, more often than not, an LIC will trade at a discount or premium to pre-tax NTA because of the imbalances of supply and demand in its shares. This can be influenced by the popularity of its investment mandate, effectiveness of the LIC’s communication, historical investment performance, history of dividends and franking, fee structure of the vehicle, and the quality and reputation of management. It can also be due to a function of size, liquidity, regulation and the prevailing market conditions.

Are premiums/discounts a useful guide?
Although it may seem intuitive to buy an LIC at a discount and sell at a premium to its pre-tax NTA, it is not an overly effective method of investing in an LIC. This is because an LIC can trade at greater discounts or indeed greater premiums, thus potentially impairing investment outcomes.

As shown in Figure 1 below, the average premium for a large-capitalisation LIC managing in excess of $800 million and listed on ASX, has been 1.5 per cent since 2004. However, the average trading range oscillates from a discount of 13.8 per cent to a premium of 14.6 per cent, suggesting material variation/opportunity through the cycle.

Figure 1: Large-Capitalisation LICs Average Premium and Discount

Source: Bell Potter, Bloomberg, Company Data

In effect, if we were able to buy an LIC at the average minimum discount of 13.8 per cent and sell it at the premium of 14.6 per cent, it would realise a net gain of 28.4 per cent without factoring in any positive or negative market movement. However, the opposite effect is also true, hence our opinion that premiums and discounts need to be proactively managed, particularly on entry.

Look for historical averages
Our analysis suggests that with all other things being equal, LICs have a tendency to revert to long-term premiums and discounts through the cycle. Consequently, utilising this information effectively can be a method of enhancing returns, or at the very least minimising adverse outcomes through the cycle.

As such, a better method of using premiums and discounts to pre-tax NTA is analysing their individual average discount or premium to pre-tax NTA over longer periods, then evaluating them in the context of their historical discount and premium to pre-tax NTA trading range.

An example: AFIC
For instance, Australian Foundation Investment Company (AFIC), a $6.3-billion LIC listed on ASX in 1936, has traded at an average premium of 1.25 per cent in a range between a 16.6 per cent discount to a 20.0 per cent premium since 1989.

If we had purchased AFIC on 31 March, 2012, we could have picked it up at a 7.7 per cent discount to pre-tax NTA, which is a considerable discount to its longer-term average.

If we had then offloaded it once the discount had been eroded, this would have seen us exit the trade eight months later at pre-tax NTA. Over this period the pre-tax NTA would have increased a mild 4.2 per cent, but because of the contraction on the discount the share price rose 12.5 per cent, not factoring in the 4.4 per cent in dividends and franking that were also earned during this period.

Figure 2: Australian Foundation Investment Company

Source: Bell Potter, Bloomberg, Company Data

Similarly, if the investor in this example had been lucky enough to hang on to this trade for 22 months, they could have offloaded the investment at an 8.9 per cent premium to pre-tax NTA. During that period the pre-tax NTA rose a healthy 22.5 per cent. However, the share price moved an astonishing 44.5 per cent, as the discount moved into a hefty premium.

Dividends and franking over that period contributed a further 11.8 per cent to the share price return, suggesting a cash return of 56.4 per cent. Not bad considering the NTA movement inclusive of dividends and franking increased 33.5 per cent.

Conclusion
While clearly we view managing discounts and premiums as a key priority when investing in LICs, it is one of a number of variables that need to be considered.

Investors must also evaluate the appropriateness of the mandate, performance of the vehicle, dividend policy of the company and calibre of the investment team, among a variety of other variables. Those considering an investment in LICs also need to evaluate the suitability of LICs to their investment needs, particularly in light of liquidity requirements.

Used well, LICs can be an extraordinarily effective method of gaining exposure to a variety of asset classes.

About the author

William Spraggett is a founding partner of Seed Partnerships, a specialist corporate advisory business that specialises in Listing Investment Companies. Seed Partnerships recently helped launched Future Generation Global Investment Company (ASX Code: FGG), an LIC with dual objectives of providing its shareholders with a diversified exposure to global fund managers while also seeking to change the lives of young Australian affected by mental illness.http://www.asx.com.au/products/managed-funds/lics-lits.htm

This article appeared in the November 2015 ASX Investor Update
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This article appeared in the November 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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